Essentially, it is the supply and demand for currencies in domestic and global markets that determine exchange rates. Short-term and medium-term market expectations, along with the degree of intervention by monetary authorities, influence the underlying supply and demand conditions in currency markets. These conditions are also affected by international factors, depending on the openness of the economy.

The overall supply and demand of currency in the domestic market are determined by monetary factors that are aligned with central bank policies, which have a strong bearing on interest rates in the economy. Lower interest rates vis-à-vis foreign country interest rates normally imply a weaker domestic currency, while higher interest rates imply a stronger domestic currency.

Economic policies of governments have a bearing on budgetary deficits and domestic public debt, foreign trade and balance of payments, foreign exchange reserves and external debt, inflation levels, labour market conditions, industrial and agricultural performance, and GDP growth expectations. These factors largely determine the overall outlook towards the domestic currency and its exchange rate against foreign currencies. The recent depreciation of the Indian rupee against the US dollar must be viewed in this broader perspective.

International Experiences 

From an Asian perspective, the currency crisis of 1997 in Southeast Asia elicited different responses from governments and monetary authorities. While Korea adopted a floating exchange rate system, Malaysia responded with capital controls to prevent capital flight. Both countries experienced significant economic pain but recovered in a relatively short span of time. There is, however, no clear consensus on which approach was superior.[i] The debate on the two approaches continues even today.

Events in Asia led to a reassessment of the causes and consequences of currency crises. A strong view among many Asian policymakers has been that the crises occurred because markets expected them to happen, given prevailing economic policies. The basic argument advanced was that the affected countries—Thailand, Indonesia, South Korea, the Philippines, and Malaysia—were fundamentally sound, but at some point speculators took a contrary view and came to believe that currency collapses would occur.

Based on this belief, investors refused to roll over loans denominated in these currencies once they matured. This led to a massive depletion of foreign exchange reserves due to capital flight. Unable to borrow additional reserves at prevailing interest rates, governments had to abandon fixed exchange rates, thereby validating speculators’ expectations.[ii]

Rupee Depreciation, Market Expectations

The rupee touched 91.03 to the US dollar (USD) on December 17, 2025, declining by about 6 per cent so far this year.[iii] In less than a year, the rupee has moved from around 85 to above 90 per USD, marking its second-fastest fall since the 2013 taper tantrum. From mid-November’s level of 88.5, the currency has lost over 5 per cent, making it the worst performer among major Asian currencies.

The prevailing view is not of a crisis situation but of prolonged softness. India’s macroeconomic fundamentals—moderate inflation, strong domestic investment, and stable foreign exchange reserves—are not in question. However, concerns over a widening foreign trade deficit, rising outward investment, slowing IT exports, and higher external refinancing costs persist.

Based on prevailing market expectations, analysts believe the most realistic outcome is a managed glide path by the Reserve Bank of India (RBI) to smoothen rupee volatility without defending any particular level. The net result is that importers will continue to buy dollars on dips, reinforcing the downward trend. Corporates borrowing overseas are expected to recalibrate their plans around US interest rate expectations and hedging costs.

Occasional short bursts of appreciation of the rupee against the USD are possible. However, in the absence of a structural shift in capital flows, the rupee is expected to trend lower, with markets adjusting to this reality. The IMF classifies India’s exchange-rate regime as a “crawl-like arrangement,” wherein the RBI allows gradual weakening while intervening to prevent disorderly volatility.

Such intervention, however, carries a cost. When the RBI sells dollars and subsequently buys USD to rebuild reserves, market expectations of further depreciation tend to strengthen, making the rupee weaker over time. Much therefore depends on the US Federal Reserve. If rate cuts are delayed or not implemented at the expected pace, the USD will remain strong and the rupee correspondingly weak.[iv]

Market Forces

Foreign institutional investors (FIIs), including hedge funds and large asset managers, have periodically sold Indian equities and bonds this year. When FIIs sell, they convert rupees into USD and remit funds abroad, adding to demand for the dollar and putting downward pressure on the rupee.

Between July 2025 and November 2025, FIIs sold Indian equities worth approximately ₹1.5 lakh crore.

Analysts note that the US dollar has strengthened due to developments in global bond markets and evolving central bank expectations. Higher US Treasury yields—or expectations of higher interest rates in the US and other major economies—attract capital to dollar-denominated assets, weakening other currencies. Global yield movements and policy expectations have accelerated capital outflows from India, contributing to the rupee’s decline.

Even when India’s economy is growing rapidly, capital flows seek the best risk-adjusted returns, which depend on factors beyond the control of domestic policymakers. If US assets offer higher yields and greater safety, capital shifts toward the dollar and foreign currencies weaken. Markets determine these outflows and inflows, driven by bullish and bearish expectations. No country can fully control capital movements unless there is a strong, coordinated international regulatory mechanism to restrain speculative activity.

Analysts also believe the rupee is under pressure partly because India and the US have not yet finalised a trade agreement addressing high US tariffs. Weak trade activity and subdued portfolio inflows, combined with the absence of a bilateral trade deal, have outweighed the positive impact of India’s strong current financial year second-quarter growth.

India’s inflation has remained relatively low this year. Low inflation, combined with nominal depreciation, affects the real effective exchange rate and trade competitiveness. Some analysts argue that the rupee’s nominal decline, together with low domestic inflation, has left India’s real exchange rate overvalued, thereby eroding export competitiveness.

The rupee’s fall reflects a convergence of factors—a strong global dollar cycle, foreign capital outflows, and a high import bill—playing out simultaneously. Given India’s underlying fundamentals, analysts expect the exchange rate to remain range-bound rather than experience an unchecked slide.[v]

Influence Of Geopolitics 

The interaction between geopolitical forces and global economic linkages is complex and differentiated. Economies such as China, Germany, the United Kingdom, and the United States show evidence of relatively rapid trade reconfiguration along geopolitical lines. In contrast, economies such as Brazil, India, and ASEAN nations continue to trade across geopolitical divides.

Despite reduced direct trade between China and the United States, strong indirect trade linkages persist. Trade dynamics driven by commercial considerations may move in opposite directions along the same corridor—for example, while the EU and India have reduced their export shares to China, they have increased their imports from it.

These evolving trade shifts are only one dimension of a broader geopolitical landscape. Firms and policymakers are increasingly monitoring changes in trade patterns, including geopolitical distance, as part of their strategic responses to a multi-aligned global order. While shifting geopolitical geometry introduces risks, careful navigation may also create new opportunities.[vi]

While geopolitics shapes the strategic alignment of nations, day-to-day market expectations largely determine currency positions. These expectations, in turn, have significant repercussions for currency outlooks and exchange rate movements.

References

[i] Rhee, Chang Yong. Korea’s Integrated Policy Framework Story: Extending into the Effective Lower Bound Era 2025 Michel Camdessus Central Banking Lecture* International Monetary Fund September 18, 2025 https://www.imf.org/-/media/files/news/speech/2025/2025-camdessus-lecture.pdf

[ii]Craig Burnside, Martin Eichenbaum, and Sergio RebeloWhat Caused the Recent Asian Currency Crises? https://www.elibrary.imf.org/display/book/9781451965476/ch003.xml16 Jan 2001

[iii] Rupee Breaches 91/$ ,declines 6% this year,Times of India ,Newdelhi,December 17,2025,p19.

[iv] Rupee depreciation: The currency faces a slow, structural slide

Policy Circle Bureau — December 8, 2025

https://www.policycircle.org/economy/rupee-depreciation-structural-slide/

[v]Reasons and Repercussions of Falling Indian Rupee,Dec 8,2025https://www.icicidirect.com/research/equity/finace/falling-indian-rupee-reasons-and-repercussions

[vi] J,seong et al, geopolitics and geometry of global trade,2025 updateJanuary 27 2025https://www.mckinsey.com/mgi/our-research/geopolitics-and-the-geometry-of-global-trade-2025-update?stcr=D31548A12E7A46E7AADA8045C00E1E5C&cid=eoy_2025-eml-nsl-ttn-mgp-glb--&hlkid=9d6e9cac4d84457f907da2063e51ee8a&hctky=10588504&hdpid=04a317bc-82ff-436a-ac0c-629152d8b924#/

(The writer is a retired Special Secretary, Government of India. Views expressed are personal. He can be reached at ppmitra56@gmail.com.)